We’ve heard a lot recently about the Paradox of Thrift. The most common explanation is this: as a country we need to save more and consume less, but if we all try to save at the same time, consumption falls too much, businesses lay off workers, income falls and we aren’t able to save more. This results in a negative feedback loop where as more people reduce consumption, income falls which leads to more reductions in consumption which leads to more layoffs and even less consumption. The paradox is that a good idea for an individual, if practiced widely, is bad for the economy as a whole.

The Keynesian response to this situation is for the government to step into the breach and spend when individuals (or corporations) can’t or won’t. This solution is in itself a paradox. Consider these sentences:

Our economy has consumed too much and the solution to this problem is to consume more.

Our economy has too much debt and we will solve this problem by increasing our debt.

If the definition of paradox is an assertion that is self contradictory, these two sentences certainly fit the bill. How can the answer to our problem of too much debt be to incur more? The government can only pay for this spending the Keynesians want by borrowing more or taxing more. Raising taxes will not solve the problem because it will make the economy worse (see Great Depression). Borrowing more will not solve the problem because we will only replace private debt with public debt.

The solution to our economic problems is not to try and solve a paradox with another paradox. The logical course is to reduce our debt load and that can only be accomplished in two ways. We can either hold the debt constant and allow the economy to grow so the debt to GDP ratio is reduced or we can reduce the debt by other means. Those are our only options if we really want to solve this problem. Anything else is just kicking the can down the road and will result in a larger problem in the future.

Holding the debt constant and allowing the economy to grow is the most honest option. How could that be accomplished? The only way to raise consumption in the long run is to concentrate on production (in other words, adhere to Say’s Law). The supply side argument is to reduce the burden on producers and wealth creators. I think the only politically palatable way to do that right now is to reduce the corporate tax rate or preferably eliminate it. The Obama campaign spent too much time demonizing rich people to go back on the promise of raising their taxes now. Likewise with the capital gains tax; he can’t lower the capital gains tax after promising to raise it during the campaign. If I remember correctly, he did once say promising things about lowering corporate taxes and some Democratic members of Congress also approve (Barney Frank). The other piece of the puzzle is to cut government spending but that seems unlikely.

Reducing the debt by other means is the other option. That could take several paths and some of them will likely be in use over the next few years. Most obvious is bankruptcy; overindebted consumers and companies need to go through bankruptcy and bond holders will have to take the hit. That would certainly go a long way toward ending our culture of debt. Lenders will be very reluctant to extend credit in the future if they take a big hit now. The other option for reducing the overall debt burden is for the government to inflate away the problem. Just turn on the printing press and print up enough to pay back creditors in devalued dollars. Frankly, that is probably what is going to happen.

Obviously, the debt reduction has to happen. How we do it will have a big impact on how our economy looks a few years down the road. If we combine some of these solutions and avoid the really bad ones (Inflation and massive government spending) we can get out of this with an economy that is functioning. If we choose the “easy” options of government spending and inflation, we are in for a long period of stagnation.